Weighted Average Anti-dilution Protection
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Transcript of Weighted Average Anti-dilution Protection
WEIGHTED AVERAGE ANTI-DILUTION PROTECTION
Get out your calculator
By Frank Demmler
An investor in any given round of financing is concerned that the next round could be at a lower price per share
than what he is paying this round. Therefore, the investor will insist upon anti-dilution protection.
If pressed for justification, the investor may explain that if the value of a company declines between rounds,
management must be largely responsible. The investor maintains that he shouldn’t be penalized for
management’s deficiencies.
There are two common types of anti-dilution protection: full ratchet and weighted average.
Last week’s article examined full ratchet anti-dilution protection. This week we will look at weighted average
anti-dilution protection.
WEIGHTED AVERAGE ANTI-DILUTION PROTECTION
Unlike full ratchet anti-dilution protection that is effectively a “ do-over,” weighted average anti-dilution
protection gives consideration to the relationship between the total shares outstanding as compared to the shares
held by the original investor.
A reminder, investors purchase preferred stock that is convertible into common stock. Initially the conversion is
on a one-to-one basis, or at the same share price as that paid for the preferred stock. Anti-dilution protection is
implemented by adjusting the conversion price.
The legal language that is used in a term sheet to say this is:
In the event that the Company issues additional securities at a purchase price less
than the current Series A Preferred conversion price, such conversion price shall
be adjusted in accordance with the following formula:
CP2 = CP1 * (A+B) / (A+C), where:
CP2 = New Series A Conversion Price
CP1 = Series A Conversion Price in effect immediately prior to new issue
A = Number of shares of Common Stock deemed to be outstanding
immediately prior to new issue (includes all shares of outstanding
common stock, all shares of outstanding preferred stock on an as-
converted basis, and all outstanding options on an as-exercised basis;
and does not include any convertible securities converting into this
round of financing)
B = Aggregate consideration received by the Corporation with respect to
the new issue divided by CP1
C = Number of shares of stock issued in the subject transaction
National Venture Capital Association
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Let’s look at how this works.
THE FIRST ROUND
Let’s go back to our example transaction.
• I offer to invest $400,000 in your company in exchange for 40% of it.
• Since you own all 600,000 shares of your company, I am offering to buy 400,000 new shares in order to
acquire 40%.
• My investment of $400,000 divided by 400,000 shares that I’m buying yields a per share price of $1.00.
• Since you own 600,000 shares, that means the value of the stake in your company is $600,000, which is
the pre-financing value.
• Adding my $400,000 to that yields a post-financing value of $1,000,000.
• That is confirmed by taking the total number of outstanding shares, 1,000,000 (your 600,000 and my
400,000) and multiplying that by the share price of $1.00.
• That also says that the post-financing value of your company is $1,000,000.
There’s one difference this week. The terms of this deal include weighted average anti-dilution protection.
THE SECOND ROUND
It’s time to raise some more money. Unfortunately, the only investment offer you are able to attract is at a lower
price per share than the prior round.
Without anti-dilution protection, the deal would proceed:
• The new investor offers to invest $500,000 for 50% of your company.
• If 50% of the company is worth $500,000, then the total company must be worth $1,000,000.
• Since there are 1,000,000 shares outstanding today and they will represent 50% of the company after the
financing, then the new investor is buying 1,000,000 shares.
• The $500,000 investment divided by 1,000,000 shares yields a share price of $0.50.
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• Since I paid $1.00 per share, I’m not happy. In fact, the 400,000 shares that I paid $400,000 for are
now worth $200,000 (400,000 shares X $0.50 per share).
• The value of my investment has been diluted.
• In addition, the percent of the company I own has decreased (been diluted) from 40% to 20%.
• By the same reasoning, your equity stake is now only worth $300,000, and you’ve only got $500,000 of
investor’s money to keep your business alive.
BUT I do have anti-dilution protection, so the deal will have needs to be adjusted.
THE ADJUSTMENT – SCENARIO #1
With anti-dilution protection, the deal would proceed:
• The new investor offers to invest $500,000 for 50% of your company.
Let’s enter the values for the variables in the weighted average anti-dilution formula:
CP2 = CP1 * (A+B) / (A+C), where:
CP2 = New Series A Conversion Price
CP1 = $1.00
A = 1,000,000
B = 500,000
C = 1,000,000
CP2 = $1.00 * (1,000,000 + 500,000) / (1,000,000 + 1,000,000)
CP2 = $1.00 * (1,500,000) / (2,000,000)
CP2 = $0.75
So, with my conversion price being reduced from $1.00 to $0.75, my 400,000 shares of preferred stock will
convert into 533,333 shares of common stock. Weighted average anti-dilution protection has given me the rights
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to 133,333 shares of common stock.
Are we done? Maybe. Maybe not.
• Deals are negotiated with percentages, but are structured with shares.
THE ADJUSTMENT – SCENARIO #2
Remember the first element of the deal:
• The new investor offers to invest $500,000 for 50% of your company.
Does that mean before, or after, consideration of the shares associated with the anti-dilution protection? If the
former, then the solution found above is correct.
If the latter, then we have to put the “Iterate” function of our spreadsheet to work again (as we did last week
with full ratchet anti-dilution protection).
This yields a transaction price per share of $0.4231, instead of $0.50. My conversion price has become
$0.6875, instead of $0.75 and the number of common stock shares to which I have rights has increased from
533,333 shares to 581,818 shares.
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THE INVESTOR OUTCOME
The new investor buys 50% of the company (or almost 50%, depending upon the scenario that’s been selected).
I get rights to less than 200,000 shares of common stock as a result of weighted average anti-dilution protection.
That’s something, but pretty modest when compared to the 2,001,000 shares that resulted from full ratchet anti-
dilution protection.
YOUR OUTCOME
Just as in the case of full ratchet anti-dilution protection, all of these adjustments have occurred to the investors’
positions. What happens to you?
It isn’t pretty. As the number of shares for the investors ratchet higher and higher, your number of shares remains
constant at 600,000.
Your share of your company is in the range of 25-30%, compared to 10% with full ratchet!
The value of your shares has dropped to less than $300,000, which is better than $100,000 in the full
ratchet case! You have paid a price for the down round, but not to the extreme of full ratchet anti-
dilution protection.
RECAP
An investor in any given round of financing is concerned that the next round could be at a lower price per share
than what he is paying this round. Therefore, the investor will insist upon anti-dilution protection.
Weighted average anti-dilution protection is more friendly to entrepreneur than full ratchet anti-dilution protection.
Next week we’ll look at the practical implications of the forms of anti-dilution protection.
Frank Demmler is Associate Teaching Professor of Entrepreneurship at the Donald H. Jones Center for Entrepreneurship at
the Tepper School of Business at Carnegie Mellon University. Previously he was president & CEO of the Future Fund,
general partner of the Pittsburgh Seed Fund, co-founder & investment advisor to the Western Pennsylvania Adventure
Capital Fund, as well as vice president, venture development, for The Enterprise Corporation of Pittsburgh. An archive of
this series of articles can be found at my website.
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